Understanding the financial crisis… In 800 words (And a video)

If you want to understand the economic crisis, there are several hundred 250-page books for you to read. If, on the other hand, you want a one-page explanation, this is it.

Beginning in the 1990’s, the U.S. became infatuated with homes as investments. The government encouraged home ownership. Private entities — Fannie Mae and Freddie Mac — were pushed to provide liquidity to the residential mortgage market. In return, the government provided an implicit backing (now $400 billion explicit) for Fannie and Freddie’s borrowings. All the smart journalists and financial writers advised Americans to drop everything they were doing and buy a house.

Really smart people — let alone ordinary Joe’s — began to believe that housing prices were like flubber — working against gravity. A commodity that had basically bounced along at a point or two over inflation for 50 years began to appreciate at 10% per year or more. With +/- 90% financing, the result was a doubling of equity every year.

With Americans wanting more and bigger houses, banks and non-banks found ways to lend them money. Lender creativity in making loans to people who could never afford them was exceeded only by lender greed. Loan officers and mortgage brokers were incented to just move money out the door.

Lenders had little reason to worry about loan repayment. Loans were sold to investment bankers. The lenders made a profit on these sales and had no ongoing risk of repayment. Then the lender went back to doing what it did well… making more ridiculous loans. Unfortunately, many banks got caught holding mortgage loans or securities before they could be foisted on others (think Citibank).

The investment bankers bundled these loans into mortgage securities (a financial instrument divided into risk levels) and sold them off into the investment community, making money in the process of course. However, these sales would not have been possible without the compliance of the ratings agencies who blessed these toxic packages with AAA ratings, and oh yes, collected their fees from the investment banks selling the mortgage securities.

All the while, the government slept well believing that housing prices never fall and as long as prices rise, people can refinance if they get into trouble. As a result, no one in Washington bothered to investigate the kind of loans people were receiving or, the awful processes by which these loans were being underwritten and marketed.

The proverbial poopy hit the fan when housing prices started to flatten and refinancings became increasingly difficult. Even crazy lenders could not loan more than houses were worth and when prices flattened, there was no new equity to lend against. As a result, people actually had to pay (instead of repay) their mortgages.

And the trouble began. As people started to default on their mortgages (2nd half of 2006), mortgage securities dropped in value and the entire system of credit default swaps was engaged. What’s a credit default swap? It’s insurance against a default. Some smart people not only bought these swaps to insure against their investment in mortgage securities, they also bought them naked. The investors were clothed, it’s just that the swaps were purchased without any corresponding investment in a mortgage security. In other words, the swaps were nothing more than a high-stakes gamble that the U.S. housing market would go bust.

And who in the world was selling these credit default swaps? Can you spell A.I.G.? I hope so because you own about $200 billion worth of it.

And by 2007 – 2008 the whole system starts to fail. Like the body shutting down after a long night of too much alcohol. Banks and investment banks realize they are holding lots of toxic (worthless?) debt instruments, and so they hang on to their capital for dear life. They stop trusting each other and the U.S. economy starts to freeze up.

Finally, an alarm clock goes off in Washington. It decides to help Bear Stearns survive but not Lehman Brothers. It decides to borrow $700 billion from U.S. children and their children (our kids and grandkids) to help the banking world survive. I for one felt it was only right to ask my granddaughter about this, and she confirmed that she wanted to help out Goldman Sachs.

In short, the economic crisis was caused by DNA – the genetic code of human beings prodding them toward pleasure (easy money) and away from pain (clear-headed analysis, fiscal discipline, patience). Let’s never expect human beings to act any differently. Let’s just tell this tale to our kids and grandkids so that they will be better able to see the train coming at them the next time around.